**3.2 Transition risks**

Transition risks arise as a result of the shift to a low-carbon economy (such as changes in public regulation, technology, or in households' or investors' preferences) triggering changes in demand-related factors. This adjustment process is likely to have a significant impact on the economy and, in particular, on some financial asset values [11].

Transition risks are characterized by a radical uncertainty on the nature of the low-carbon pathway (i.e., the pathway for reducing greenhouse gas emissions, which restructures the economy) and a more usual uncertainty on the methods for implementing this pathway in economic and social terms [23].

Over the last few years, the topic of stranded assets, caused by risk factors like physical climate change impacts, as well as societal and regulatory responses to climate change, has loomed larger [24]. Stranded assets are defined as assets that have suffered from unanticipated or premature write-downs, devaluations, or conversion to liabilities [25]. With transition toward a lower-carbon economy, carbon assets are expected to suffer from unanticipated or premature write-offs, downward revaluations, or get converted to liabilities [26].

Estimation by McGlade and Ekins [27] shows that approximately one third of the current oil reserves, half the gas reserves, and almost 90% of the coal reserves

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financiers [32].

*Climate Change, Credit Risk and Financial Stability DOI: http://dx.doi.org/10.5772/intechopen.93304*

will be for effective transition measures [21].

**4. Credit risks implications of climate change**

**3.4 Liability risks**

externalities [21].

the loan [30].

would become stranded assets if global temperature target of the Paris Agreement is attained. While an early and smooth transition results in much fewer risks, too rapid an adjustment of asset prices due to a late transition might eventually bring

Physical risk and transition risks are correlated, because the more transition policies enter into force, the fewer physical risks are likely to materialize. On the other hand, the harder the economy is hit by physical risks, the stronger the demand

Materializing physical and potentially also transition risks will drive up liability risks [21]. Liability risks materialize when organizations are directly or indirectly adjudged legally responsible for climate-related losses and must financially compensate other parties [28, 29]. Organizations are also prone to increasing liability risk if they do not manage transition risks well as enshrined in the polluter pays principle. Organizations whose activities are negatively affected by unmitigated climate change could seek compensation from those who had caused or allowed the damage and thereby at least partially internalize the negative

Credit risk is the risk of a financial loss resulting from a borrower's failure to repay part of or all the interests and the principal of a loan. Climate-related risks affect all three dimensions of credit risk—a borrower's capacity to generate enough income to service and repay its debt as well as the capital and collateral that back

For financial institutions, credit risks can materialize directly, through their exposures to corporations, households, and countries that experience climate shocks, or indirectly, through the effects of climate change on the wider economy and feedback effects within the financial system. Exposures manifest themselves through increased default risk of loan portfolios or lower values of assets [31]. Corporate credit portfolios are also at risk, as highlighted by the PG&E's bankruptcy. Increase in extreme and severe weather events could have second-round effects on the price of corporate bonds, and the rise in debt defaults would induce climate-related financial instability which would adversely affect credit expansion and magnify the negative impact of climate change on financial activity [19]. Transition risks materialize on the asset side of financial institutions, which could incur losses on exposure to firms with business models not built around the economics of low-carbon emissions [31]. Climate change mitigation policies to reduce GHG emissions can create costs for carbon-intensive sectors and companies, thereby influencing the credit quality of GHG-intensive borrowers and also credit risks to banks [32]. Ongoing developments in the international climate policy arena show there will be more rigorous future global climate policy regime. Noncompliance with mitigation policies might become reputational risks and therefore credit risks. Hence, both compliance and noncompliance with the mitigation policies will have implications for loan providers, equity investors, and project

about a climate Minsky moment—a sudden drop in assets prices [21].

**3.3 Relationship between physical and transition risks**

would become stranded assets if global temperature target of the Paris Agreement is attained. While an early and smooth transition results in much fewer risks, too rapid an adjustment of asset prices due to a late transition might eventually bring about a climate Minsky moment—a sudden drop in assets prices [21].
